Avoiding Another Year of Living Dangerously: Time to Secure Financial Stability

In various guises, the “Year of Living Dangerously” has been used to describe the global financial crisis, the policy response to the crisis, and its aftermath.

But, we’ve slipped well beyond a year and the financial system is still flirting with danger. Durable financial stability has, so far, proven elusive.

Financial stability risks may have eased, reflecting improvements in the economic outlook and continuing accommodative policies. But those supportive policies—while necessary to restart the economy—have also masked serious, underlying financial vulnerabilities that need to be addressed as quickly as possible.

Many advanced economies are “living dangerously” because the legacy of high debt burdens is weighing on economic activity and balance sheets, keeping risks to financial stability elevated.

At the same time, many emerging market countries risk overheating and the build-up of financial imbalances—in the context of rapid credit growth, increasing asset prices, and strong and volatile capital inflows.

Here is our suggested roadmap for policymakers to address these vulnerabilities and risks, and achieve durable financial stability.

Heeding the warning signs

Challenges in four key areas put financial stability at risk.

Confidence in the banking system has yet to be fully restored, nearly four years since the start of the global financial crisis. Progress in strengthening capital positions and reducing leverage has been uneven. There is considerable uncertainty about the quality of some bank assets, particularly exposures to higher-risk sovereigns and real estate in some countries. And a weak tail of undercapitalized banks remains. We have analyzed the sample of banks that European authorities used in last year’s stress tests. This snapshot of end-2010 data revealed that 30 per cent of these banks—representing a fifth of their total assets—have Core Tier 1 capital ratios of less than 8 percent. This makes them less able to withstand shocks and secure cost-effective funding.

To solve these problems, we need comprehensive policies to increase bank transparency, raise capital buffers, and restructure and resolve weak banks. The forthcoming stress tests by the European Banking Authority are an important opportunity to assess the health of the EU banking system. But the tests need to be credible, stringent, and part of a broader crisis management strategy that includes backstops against capital shortfalls.

Sovereign balance sheets remain under strain in several advanced economies. Certain countries in the euro area are especially at risk, because market concerns about the sustainability of public debt have prompted a sharp increase in funding costs and restricted credit supply, creating an adverse feedback loop with the real economy. These financial stability risks need to be addressed through strategies that combine medium-term budget deficit reduction with adequate multilateral backstops for crisis countries.

Sovereign funding challenges could extend beyond the euro area. Both the United States and Japan are sensitive to higher funding burdens if interest rates increase substantially from current levels. Consequently, these countries need to take decisive action to ensure the sustainability of their public finances over the medium term.

Household indebtedness in the United States remains elevated. This could negatively affect bank balance sheets, credit availability, and house prices. And, this could be a drag on the global economic recovery.

More structural policies may be needed to address high household debt, including principal write-downs on mortgages. Our analysis shows that US banks are strong enough to withstand sizeable reductions in the principal of risky mortgages.

Policymakers in emerging markets need to guard against overheating and a buildup of financial imbalances. A number of factors point to the incubation of financial imbalances, including:

Exceptionally strong bank credit growth in some countries. Experience shows that there is a close connection between high credit growth and future increases in non-performing loans.

Strong, and more volatile, capital inflows. Capital inflows are not yet excessive, but recent volatility has already tested the absorptive capacity of some emerging markets.

Putting danger behind us

So what can policymakers do to achieve durable financial stability?

Advanced economies need to deal with the legacy of the crisis—effectively and immediately. They must reduce their reliance on policies that mainly responded to the symptoms of the crisis, and increase their focus on measures that address the underlying causes. In particular, they need to fully repair their banking systems, strengthen sovereign balance sheets, and reduce household debt burdens.

By contrast, emerging economies need to act—before it’s too late—to avoid future crises. Given the risk of overheating and financial imbalances, policymakers need to make more, and better, use of macroeconomic measures, such as official rate hikes, more flexible exchange rates, and fiscal tightening. Macroprudential policies and, in some cases, capital controls can play a supportive role.

Of course, internationally consistent regulation is the cornerstone on which a safer global financial system can be built. Advanced economies and emerging markets, therefore, have a shared responsibility to press ahead with regulatory reforms.

No one said it was going to be easy

The task ahead is not easy. There are very real risks: risks of complacency; of fatigue; or reluctance to make hard policy choices.

Action is needed now to ensure that the outstanding threats to global financial stability are dealt with once and for all. And only through international cooperation can those actions prove fully effective.

The global economic recovery will be on firmer ground only if we achieve durable financial stability.